U.S. Markets closed

Warren Buffett's Investing Rule No.1

"Rule No.1: Never lose money. Rule No. 2: Never forget rule No.1."

-- Warren Buffett

The famous quote from Buffett above has almost become a cliche in the value investing world. Like all the "big ideas" in value investing, it sounds so easy in theory but in practice, it is hard. I don't know any investor who wants to lose money, but I know plenty who have. If Rule No.1 is the golden rule in value investing, why hasn't it been strictly followed? It seems like an oxymoron.

For many years, my understanding of the concept of "losing money" had been "selling for less than you paid." Well, you can say that's a silly and obvious statement. If we go a step further and invert, we can reword it as "paying more than what you sell for." Subsequently, the question becomes, what causes us to pay more than what we sell for?

Let's use a matrix to simplify things a bit. Below, I've listed the nine possible scenarios that can occur after we purchase the equity of a business.


Income/multiple

Increase

No change

Decrease

Increase

Profit

Profit

Depends

No change

Profit

Breakeven

Loss

Decrease

Depends

Loss

Loss



There are two scenarios that may result in losses depending on the interaction of multiple change and fundamental change:

  1. Business fundamentals improve, but multiple shrinks more.
  2. Business fundamentals deteriorate, but multiple expands less.



There are three situations that guarantee losses:

  1. Business fundamentals deteriorate, and the multiple doesn't change.
  2. Business fundamentals do not change, but multiple declines.
  3. Both business fundamentals and the multiple deteriorate - the most dreadful situation.



Based on the above scenario analysis, we can conclude at least that if the fundamentals of the business don't grow, the chances are fairly high that investment losses will follow. If the fundamentals of the business grow, the probability of investment loss is very low - the only way to lose money when the business earns more money is when the multiple shrinks faster.

And if we look at the mistakes that Buffett has made after he transitioned from the Ben Graham approach to the new era of quality businesses, we can see that most of the mistakes are a result of the deterioration of business fundamentals - Dexter Shoes, IBM (NYSE:IBM), Tesco, Kraft Heinz (NASDAQ:KHC) and General Re.

So perhaps what Buffett really meant when he said "Don't lose money" is more in the spirit of "Don't buy businesses with deteriorating fundamentals" or "Get the odds on your side by investing in businesses with improving fundamentals."

Above is just the first level of the message. More importantly, Buffett has perhaps another message hidden in Rule No.1 - when does loss occur. It's a very important message.

Let us get back to the core of value investing: circle of competency and intrinsic value. If a business is within our circle of competency, we should be able to calculate its intrinsic value range and buy it only if it trades below its intrinsic value. Intrinsic value should be defined as the present value of all the future cash flows discounted at the appropriate discount rate.

Now, there's only one way we can lose money - paying a price higher than the intrinsic value. Then the question becomes, what causes us to do just that?

The first thing that comes to my mind is operating outside of the circle of competency because if we are doing so, we simply can't calculate the company's intrinsic value. So the probability of us paying a price higher than the intrinsic value of the business is similar to that of a coin flip, or even worse, similar to that of winning a slot machine.

But let's say the business is within our circle of competency. What would cause us to pay more than the intrinsic value? In the case of Kraft Heinz (NASDAQ:KHC), the reality changed, and the new intrinsic value based on a new set of conditions is much less than the previously calculated intrinsic value. The assumptions used to calculate the initial intrinsic value were too optimistic, or the discount rate was not high enough to account for the risk. Whatever the reason, if the newly calculated intrinsic value is less than the purchase price, a loss has occurred, regardless of the market price of the business.

Therefore, there are only two root causes of investment losses: ignorance of intrinsic value and overoptimism. From this perspective, Rule No.1 should be read as follows:

"Stick to your circle of competency and always err on the side of conservatism."

Read more here:

Bad Blood - The Most Important Lesson

5 Messages From Li Lu's Reflections

Reducing Blind Spots

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.